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Other people's money offers best returns

Have we got a deal for you. We at the Report on Business, not content to merely provide news and information, are excited to announce a new service for our valued readers. That's right: We're starting a hedge fund.

Skeptical? Don't be. You may ask what our competitive edge might be, as a bunch of failed English students trying to outfox CFAs, MBAs, PhDs and others with acronyms we don't even understand. You may worry that we're going to get eaten alive by Eric Sprott. You may wonder how we can possibly do this.

Relax. We've got a plan. We're going to do it with other people's money.

Normally, a new hedge fund like ours would keep its investment strategy top secret. Privacy is one of a hedge fund manager's greatest advantages. They jealously guard their Superior Proprietary Trading Model. We're different. Fortunately for you, we're a news organization, committed to openness and transparency.

Unfortunately for you, we don't have any proprietary trading models. But we do, as mentioned, have other people's money, some of it borrowed from a benevolent (read: stupid) banker. And we're going to take every dollar of it and buy an index fund that tracks the S&P/TSX composite.

This may seem like an awfully simple (read: idiotic) idea. Fear not. We have rigorously back-tested it, going all the way back to June 20, 2002. And we've found that bear markets are rare and short-lived, and therefore investing with the bank's money is a very good concept, since stocks always go up. Well, almost always.

So, getting back to our little fund. You may have noticed that more records have been smashed in the Canadian stock market lately than on Disco Demolition Night in Chicago in the late seventies. The TSX composite is up 16.4 per cent a year, compounded, over the past five years, thanks to high commodity prices and a furious foreign appetite for Canadian assets. If you'd put $10,000 into the TSX five years ago, you'd have $21,400 today.

While that's nice, you deserve better. So let's add a little bit of leverage. Suppose instead that you'd put $5,000 into an TSX index fund and borrowed the other $5,000. Then the return on your original equity would rise to nearly 34 per cent, before interest and other costs. Clever, no? That's what our hedge fund will do for you - for the usual management fee of 2 per cent, plus 20 per cent of profits.

You may wonder what inspired this brilliant (read: hare-brained) scheme. The answer is the implosion of two hedge funds run by Bear Stearns, the huge Wall Street investment bank. Collectively, the two funds had about $20-billion (U.S.) in investments, much of it in loans and securities that are tied to oh-so-solid subprime mortgages.

That's not the astonishing part; hedge funds blow up and die every month. It's that these two funds have apparently borrowed $9-billion, in an attempt to juice their returns. That's more debt than most of Canada's largest businesses - Telus, Loblaw, Rogers Communications, among others - have. Part of the hedge funds' game, it seems, was to borrow a lot of money at a lower rate of interest, invest it in mortgages and other debt with higher rate of interest (and higher risk), and collect the spread. Think of it as a bank with high fees.

If that seems to you to be a rather unsophisticated investment strategy, you're not alone. Yet it has been replicated, to the tune of billions of dollars, by other hedge funds, and why not? For as long as it works, it's a route to easy profits and those rich fees. And once it falters, as in the case of Bear Stearns, so what? You get to keep the fees you've earned. Just start another, like Brian Hunter, the guy who blew up Amaranth Advisors last year. Heads I win, tails you lose.

You may wonder how an industry that operates this way can attract $1.4-trillion in investors' money, and the answer is, "better returns." Except those seem to be fading now. The Credit Suisse/Tremont hedge fund index is up 7.9 per cent through May, less than the S&P 500 (including dividends). It trailed last year, too. Most large equity hedge funds are struggling to beat an investor with a margin account and an index fund.

Hedge funds have caught mutual fund disease: They've become too bloated for their own good. The last thing the world needs is another one. Except for ours, because we can't resist a deal this good.

© 2007 The Globe and Mail. All rights reserved.

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